Chapter One

Introduction to Accounting and Business

Objectives
After studying this chapter, you should be able to:
 Describe the nature of a business.
 Describe the role of accounting in business.
 Describe the profession of accounting.
 Summarize the development of accounting principles and relate them
to practice.
 State the accounting equation and define each element of the
equation.
 Explain how business transactions can be stated in terms of the
resulting changes in the basic elements of the accounting equation.
 Describe the financial statements of business organizations and
explain how they interrelate.
1.1. Introduction
Do you use accounting? Yes, we all use accounting information in one form
or another. For example, when you think about buying a house, you use
accounting-type information to determine whether you can afford it or not.
Similarly, when you decided to attend college, you consider the costs (the
tuition, textbooks, and so on). Most likely, you also consider the benefits (the
ability to obtain a higher-paying job or a more desirable job).
Is accounting important to you? Yes, accounting is important in your personal
life as well as your career, even though you may not become an accountant.
For example, assume that you are the owner/manager of a small restaurant
and you are considering opening another restaurant in a neighboring town.
Accounting information about the restaurant will be a major factor in your
deciding whether to open the new restaurant and the bank’s deciding
whether to finance the expansion.
The primary objective of this course is to illustrate basic accounting concepts
that will help you to make good personal and business decisions. We begin

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by discussing what a business is, how it operates, and the role that
accounting plays.

1.2. Nature of a Business

You can probably list some examples of companies with which you have
recently done business. Your examples might be large international
companies or they might be local companies. What do all these businesses
have in common that identify them as businesses?
In general, a business is an organization in which basic resources
(inputs), such as materials and labor, are assembled and processed to
provide goods or services (outputs) to customers.
A business’s customers are individuals or other businesses who purchase
goods or services in exchange for money or other items of value.
The objective of most businesses is to maximize profits. Profit is the
difference between the amounts received from customers for goods or
services provided and the amounts paid for the inputs used to provide
the goods or services. Some businesses operate with an objective other than
to maximize profits. The objective of such nonprofit businesses is to provide
some benefit to society, such as medical research or conservation of natural
resources. In other cases, governmental units such as cities operate water
works or sewage treatment plants on a nonprofit basis. We will focus in this
course on businesses operating to earn a profit. Keep in mind, though, that
many of the same concepts and principles apply to nonprofit businesses as
well.
1.2.1. Types of Business
There are three different types of businesses that are operated for profit:
manufacturing, merchandising, and service businesses. Each type of
business has unique characteristics.
 Manufacturing businesses: change basic inputs into products that
are sold to individual customers.

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  Merchandising businesses: also sell products to customers.
However, rather than making the products, they purchase them from
other businesses (such as manufacturers). In this sense,
merchandisers bring products and customers together.
 Service businesses: provide services rather than products to
customers.
1.2.2. Types of Business Organizations
The common forms of business organization are proprietorship,
partnership, and corporation. In the following paragraphs, we briefly describe
each form and discuss its advantages and disadvantages.
A proprietorship is owned by one individual. The popularity of this form is
due to the ease and the low cost of organizing. The primary disadvantage of
proprietorships is that the financial resources available to the business are
limited to the individual owner’s resources. The owner (proprietor) receives
any profits, suffers any losses, and is personally liable for all debts of the
business. There is no legal distinction between the business as an economic
unit and the owner, but the accounting records of the business activities are
kept separate from the personal records and activities of the owner.
As a business grows and more financial and managerial resources are
needed, it may become a partnership. A partnership is owned by two or
more individuals. Each owner is a partner. Typically, a partnership
agreement (written or oral) sets forth such terms as initial investment, duties
of each partner, division of net income (or net loss), and settlement to be
made upon death or withdrawal of a partner. Each partner generally has
unlimited personal liability for the debts of the partnership.
A corporation is organized under state or federal statutes as a separate
legal taxable entity. The ownership of a corporation is divided into shares of
stock. A corporation issues the stock to individuals or other businesses, who
then become owners or stockholders of the corporation. A primary
advantage of the corporate form is the ability to obtain large amounts of
resources by issuing stock. For this reason, most companies that require

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large investments in equipment and facilities are organized as corporations.
The holders of the shares (stockholders) enjoy limited liability; that is,
they are not personally liable for the debts of the corporate entity.
1.2.3. Business Stakeholder
A business stakeholder is a person or entity having an interest in the
economic performance of the business. These stakeholders normally include
the owners, managers, employees, customers, creditors, and the
government.
The owners who have invested resources in the business clearly have an
interest in how well the business performs. Most owners want to get the
most economic value for their investments. To the extent that the business is
profitable, owners will expect to share in the business profits.
The managers are those individuals who the owners have authorized to
operate the business. Managers are primarily evaluated on the economic
performance of the business. The managers of poor-performing businesses
are often fired by the owners. Thus, managers have an incentive to
maximize the economic value of the business.
The employees provide services to the business in exchange for a
paycheck. The employees have an interest in the economic performance of
the business because their jobs depend upon it. During business downturns,
it is not unusual for a business to lay off workers for extended periods of
time. Whenever a business fails, the employees lose their jobs permanently.
Employee labor unions often use the good economic performance of a
business to argue for wage increases.
The customers may also have an interest in the continued success of a
business. For example, if one computer manufacturer were to fail, customers
might not be able to get hardware and software for their computers.
Like the owners, the creditors invest resources in the business by extending
credit, such as a loan. They, too, have an interest in how well the business
performs. In order for the creditors to recover their investment, the business
must generate enough cash to pay them back. In addition, creditors view the

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business as their customer and thus have a stake in the continued success of
the business.
Various governments have an interest in the economic performance of
businesses. City, county, and federal governments collect taxes from
businesses within their jurisdictions. The better a business does the more
taxes the government can collect.
1.3. The Role of Accounting in Business
What is the role of accounting in business? The simplest answer to this
question is that accounting provides information for managers to use in
operating the business. In addition, accounting provides information to
other stakeholders to use in assessing the economic performance and
condition of the business.
In a general sense, accounting can be defined as an information system
that provides reports to stakeholders about the economic activities and
condition of a business.
Accounting is the process of recording, summarizing, analyzing,
reporting financial (money-related) activities and interpreting financial
information to different parties to make informed judgments and decisions.
Accounting is an art of correctly recording the day to day business
transactions. It is a science of keeping the business records in a regular and
most systematic manner so as to know the business results. Therefore, it is
an information system that provides reports to stakeholders about the
economic activities and condition of a business.
You may think of accounting as the “language of business.” This is
because accounting is the means by which business information is
communicated to the stakeholders. The better you understand the language,
the better your decisions will be, and the better you can manage your
finances.
A business must first identify its stakeholders. It must then assess the
various informational needs of those stakeholders and design its
accounting system to meet those needs. Finally, the accounting system

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records the economic data about business activities and events, which the
business reports to the stakeholders according to their informational needs.
Stakeholders use accounting reports as a primary source of information on
which they base their decisions.
1.3.1. Users of Accounting Information
Every element of society - from the individual to an entire industry or
government branch - has a need for accounting information to make
decisions on how to allocate its resources. Decision makers need
information. The information that a user of financial information needs
depends upon the kinds of decisions the user makes. There are two
broad groups of users of financial information: internal users and external
users.
a) Internal Users
Internal users of accounting information are those individuals inside a
company who plan, organize, and run the business. These include
marketing managers, production supervisors, finance directors, and
company officers.
Managerial accounting provides internal reports to help users make
decisions about their companies. Examples are financial comparisons of
operating alternatives, projections of income from new sales campaigns, and
forecasts of cash needs for the next year.
b) External Users
External users are individuals and organizations outside a company
who want financial information about the company. The two most
common types of external users are investors and creditors. Investors
(owners) use accounting information to make decisions to buy, hold, or sell
ownership shares of a company. Creditors (such as suppliers and bankers)
use accounting information to evaluate the risks of granting credit or lending
money.
The information needs of external users vary considerably. Taxing
authorities (such as the Internal Revenue Service) want to know whether

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the company complies with tax laws. Regulatory agencies, such as the
Securities and Exchange Commission and the Federal Trade Commission,
want to know whether the company is operating within prescribed rules.
Customers are interested in whether a company will continue to honor
product warranties and support its product lines. Labor unions want to
know whether the owners can pay increased wages and benefits.
Financial accounting answers these questions. It provides economic and
financial information for investors, creditors, and other external users.
1.3.2. Characteristics of Accounting Information
The following are characteristics of accounting information.
Understandability: implies the expression, with clarity, of accounting
information in such a way that it will be understandable to users - who are
generally assumed to have a reasonable knowledge of business and
economic activities.
Relevance: implies that, to be useful, accounting information must assist a
user to form, confirm or maybe revise a view - usually in the context of
making a decision (e.g. should I invest, should I lend money to this business?
Should I work for this business?)
Consistency - implies consistent treatment of similar items and application
of accounting policies
Comparability - implies the ability for users to be able to compare similar
companies in the same industry group and to make comparisons of
performance over time. Much of the work that goes into setting accounting
standards is based around the need for comparability.
Reliability - implies that the accounting information that is presented is
truthful, accurate, complete (nothing significant missed out) and capable of
being verified (e.g. by a potential investor).
Objectivity - implies that accounting information is prepared and reported
in a "neutral" way. In other words, it is not biased towards a particular user
group or vested interest.
1.4. Generally Accepted Accounting Principles

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If the management of a company could record and report financial data as it
saw fit, comparisons among companies would be difficult, if not
impossible. Thus, financial accountants follow generally accepted
accounting principles (GAAP) in preparing reports. These reports allow
investors and other stakeholders to compare one company to another. A
standard set of generally accepted accounting principles allows for the
comparison of financial performance and condition across
companies.
Accounting principles and concepts are standards or guidelines that
the accountant should follow in identifying, measuring, recording
and reporting the financial statements of an organization.
Accounting principles and concepts develop from research, accepted
accounting practices, and pronouncements of authoritative bodies. They are
the framework for the entire accounting process.
In this chapter and throughout this course, we emphasize accounting
principles and concepts. It is through this emphasis on the “why” of
accounting as well as the “how” that you will gain an understanding of the
full significance of accounting. Below we discuss some of the principles.
 Business Entity Concept: It implies that the accounting records for
the financial activities of an organization should be separate and
distinct from the financial activities of its owners or the organization.
The business entity concept is important because it limits the
economic data in the accounting system to data related directly to
the activities of the business. In other words, the business is viewed
as an entity separate from its owners, creditors, or other stakeholders.
 Going Concern Concept: The going concern principle assumes that
any organization will continue to operate its business for the foreseeable
future. The principle purports that every decision in a company is taken
with the objective in mind of running the business rather than that of
liquidating it.

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  The Cost Concept: This states that all assets are recorded in the books
of accounts at their purchase price, which includes cost of acquisition,
transportation and installation and not at its market price. It means
that fixed assets like building, plant and machinery, furniture, etc are
recorded in the books of accounts at a price paid for them. For
accounting purpose, the market value of assets is not taken into
account either for valuation or charging depreciation of such assets.
Using the cost concept involves two other important accounting
concepts— objectivity and the unit of measure.
 Objectivity Concept: The objectivity concept requires that the
accounting records and reports be based upon objective evidence. In
exchanges between a buyer and a seller, both try to get the best price.
Only the final agreed upon amount is objective enough for
accounting purposes. If the amounts at which properties were
recorded were constantly being revised upward and downward based on
offers, appraisals, and opinions, accounting reports could soon become
unstable and unreliable.
 Unit of Measurement Concept: The unit of measurement concept
requires that economic data be recorded in birrs. Money is a
common unit of measurement for reporting uniform financial data and
reports.
1.5. Business transactions and the Accounting Equation
Transactions (business transactions) are a business’s economic events
that affect the financial position of the business and can be recorded
realizably. Transactions may be external or internal. External
transactions involve economic events between the company and some
outside enterprise. For example, ABC Company purchase of equipment from
a supplier, payment of monthly rent to the landlord, and sale of goods and
services to customers are external transactions. Internal transactions are
economic events that occur entirely within one company. For example, the
use of supplies is internal transactions.

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A transaction is any activity that changes the value of a firm’s assets,
liabilities, or owner’s equity. Each transaction has a dual effect on the basic
accounting elements. A transaction may affect more than two accounts in a
transaction. This is called a combined entry.
1.5.1. The Elements of Accounting Equation
Assets: are resources with money value that a business owns. The business
uses its assets in carrying out such activities as production and sales. The
common characteristic possessed by all assets is the capacity to provide
future services or benefits. In a business, that service potential or future
economic benefit eventually results in cash inflows (receipts). Some
examples are: cash, accounts receivable (selling goods or services on credit),
plant, property & equipment, and supplies (office, store, delivery, etc.).
Liabilities: are debts owed by the business. They are claims against
assets—that is, existing debts and obligations. Businesses of all sizes
usually borrow money and purchase merchandise on credit. These economic
activities result in payables of various sorts. Some examples are: accounts
payable, notes payable, wage or salary payable, tax payable etc.
Owner’s equity: is the ownership claim on total assets is owner’s
equity. It is equal to total assets minus total liabilities. Here is why: The
assets of a business are claimed by either creditors or owners. To find out
what belongs to owners, we subtract the creditors’ claims (the liabilities)
from assets. The remainder is the owner’s claim on the assets—the owner’s
equity. This can also be called capital, proprietorship, or net worth.
In a proprietorship, owner’s investments and revenues increase owner’s
equity and owner’s drawings and expenses decrease owner’s equity.
Investments by owner: are the assets the owner puts into the business.
These investments increase owner’s equity. They are recorded in a category
called owner’s capital.
Revenues: are the gross increases in owner’s equity resulting from
business activities entered into for the purpose of earning income.

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Generally, revenues result from selling merchandise, performing services,
renting property, and lending money.
Drawings: An owner may withdraw cash or other assets for personal use.
We use a separate classification called drawings to determine the total
withdrawals for each accounting period.
Expenses are the cost of assets consumed or services used in the
process of earning revenue. They are decreases in owner’s equity that
result from operating the business. For example, wages expense; utility
expense, supplies expense, rent expense; interest expense; and property tax
expense.
The Accounting equation is therefore:

Assets = Liabilities + Owner’s Equity

This equation must always balance!

Each transaction increases or decreases (or both) the basic elements in the
accounting equation. The effect of recording a business transaction must
always leave the two sides of the accounting equation in balance.
Example
Consider the following business transactions and determine the effect of the
transactions on the basic accounting equation:
a. Invested Br. 10,000 cash in the business. (Increase both asset and
owner’s equity)
b. Purchased supplies on account, Br. 600. (Increase both asset and liability)
c. Received cash for providing a service, 1,500. (Increase both asset &
owner’s equity)
d. Paid Br. 500 expenses in cash. (Decrease both asset and owner’s equity)
e. Withdrawal of Br. 2,000 cash by owner. (Decrease both asset and owner’s
equity)
f. Received Br. 1,000 cash from a customer who had previously been billed
for services provided. (Increase one asset and decrease another asset)
Illustration:

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Assume that on September 1, 2014, Mr. Fasil established a sole
proprietorship business under the name Fasil Company. Fasil completed the
following transactions during the month of September:
a. Open a business bank account with a deposit of $11,500
b. Purchase computer equipment for $5,200 cash
c. Purchase supplies on account, $650
d. Fasil Company earns service revenue by providing various services to
customers, earning fee of birr 3,200 and received the amount in cash
e. Paid creditors on account, $450
f. Received cash from Mr. Fasil as an additional investment, $1,050
g. Charged customers for service rendered on account, $1,600
h. Paid the following: wage expense, $1,200; rent expense, $ 750; utilities
expense, $180; miscellaneous expense, $70
i. Determined by taking an inventory, the cost of supplies on hand is
$350
j. Withdraw cash for personal use, $1,500
Instruction:
1. Identify the effects of each transaction and the balance after each
transaction in tabular form.
2. Prepare i) Income statement for September
ii) Statement of owners’ equity for September
iii) Balance sheet as of September 30, and
iv) Statement of cash flow for September

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 Assets = Liabilities + Owner'
s
Equity
Cash Supplie Accounts Computer Accounts Fasil
s Receivabl Equipme Payable Capital
e nt
a. 11,500 - - - - 11,500 Initial Capital
b. (5,200) - - 5,200 - -
Bal 6,300 - - 5,200 - 11,500
.
c. - 650 - - 650
Bal 6,300 650 - 5,200 650 11,500
.
d. 3,200 - - - - 3,200 Fees Earned
Bal 9,500 650 - 5,200 650 14,700
.
e. (450) - - - (450) -
Bal 9,050 650 - 5,200 200 14,700
.
f. 1,050 - - - - 1,050 Additional
Inv't
Bal 10,100 650 - 5,200 200 15,750
.
g. - - 1,600 - 1,600 Fees Earned
Bal 10,100 650 1,600 5,200 200 17,350
.
h. (2,200) - - - - (1,200) Wage
(750) Expenses
(180) Rent
(70) Expenses
Utilities
Expenses
Misc.

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 Expenses
Bal 7,900 650 1,600 5,200 200 15,150
.
i. - (300) - - - (300) Supplies
Expense
Bal 7,900 350 1,600 5,200 200 14,850
.
j. (1,500) - - - (1,500) Withdrawal
Bal 6,400 350 1,600 5,200 200 13,350
.

1.6. Financial Statements

Summaries of financial activities are called financial statements which
are prepared on a regular basis at the end of an accounting period. The
accounting period typically is one year; however, it can be any length of time
for which records are maintained. Usually the minimum is one month and the
maximum length of time is one year for financial statements.
There are several financial statements. The following are financial
statements for sole proprietorship.
 Income Statement,
 Statement of Owner’s Equity
 Balance Sheet
 Cash flow statement
Income Statement: is a summary of a business’s revenue and expenses for
a specific period of time, such as a month or a year. It only shows revenue
and expenses. The income statement, also called the statement of
earnings or statement of operations, it presents a moving picture of
operations during the period. The income statement holds one of the most
important pieces of information about a business—whether it earned:
Net Income is realized when revenue exceeds expenses.

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 Net loss is realized when expenses exceed revenue.
The income statement for Fasil Company is shown below:
Fasil Company
Income statement
For the month ended September 30, 2014
Revenue (Fees $4,80
earned) ................................ 0
Less Operating Expenses
Wages 1,200
expenses...............
Rent 750
expense..................
..
Supplies 300
expense..............
Utilities 180
expense...............
Misc. 70
expense..................
.
Total Operating 2,500
Expenses...........................
Net $2,30
Income.................................... 0
............
Statement of Owner’s Equity: is a summary of the changes that have
occurred in the owner’s equity during a specific period of time. This
statement will show either an increase or decrease in the capital account.
Increases in owner’s equity come from:
 Owner investments
 Net income
Decreases in owner’s equity result from:
 Owner withdrawals
 Net loss
The statement of Owners equity for Fasil Company is shown below:
Fasil Company
Statements of Owner's Equity
For the month ended September 30, 2014

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 Fasil, Capital September 1, 2014.........................
$11,500
Additional 1,05
investment................................. 0
Net Income for the 2,30
month........................... 0 3,350

$14,850
Less withdrawal during the
month......................... (1,500)
Fasil, Capital, September 30,
2014..................... $13,35
0
Balance Sheet: This statement is a listing of the firm’s assets,
liabilities, and owner’s equity at a specific date, usually the end of a
month or a year. Total Assets must equal the addition of Liabilities and
Owner’s Equity.
The balance sheet for Fasil Company is shown below
Fasil Company
Balance Sheet
September 30, 2014
Assets Liabilities and Owner's
equity
Cash 6,400 Liabilities:
Supplies 350 Accounts Payable 200
Accounts 1,600 Owner's Equity
Receivables
Computer Equip. 5,200 Fasil, Capital 13,350
Total Asset $13,550 Total Liabilities & Owner's 13,550
equity
Statement of cash flow: shows the cash inflow and cash out flow during a
given period of time. There are three sections in this statement. These are;

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 Cash flow from operating activities: Under this section, cash
received from customer and cash paid to creditors and expenses are
included.
Cash flow from investing activities: This section includes cash
received from sale of relatively long-term assets and cash paid to
acquire plant assets.
Cash flow from financing activities: Investment by owners and
drawings are included under this section.
The cash flow statement for Fasil is prepared as follows:
Fasil Company
Statements of Cash Flow
For the month ended September 30, 2014
Cash flow from operating activities:
Cash received from customers………………………………… $3,200
Cash paid to creditors and expenses…………………………. (2,650)
Net cash flow from operating activities………………………………………….
$550
Cash flow from investing activities:
Cash received from sale of plant assets………………………….. $0
Cash paid to acquire plant assets (machine)………………… (5,200)
Net cash flow from investing activities……………………………………...
($5,200)
Cash flow from financing activities:
Cash received from owner’s investment……………………. $11,500
Cash received as an additional Investment.............................1,050
Cash withdrawal by owners………………………………… (1,500)
Net cash flow from financing activities………………………………………
$11,050
Ending cash balance, September 30,
2014…………………………………. $6,400

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